Problem:
A firm has been experiencing low profitability in recent years. Per- form an analysis of the firm's financial position using the DuPont equation. The firm has no lease payments but has a $2 million sinking fund payment on its debt. The most recent industry average ratios and the firm's financial statements are as follows:
Industry Average Ratios
Current ratio 2× Fixed assets turnover 6×
Debt/total assets 30% Total assets turnover 3×
Times interest earned 7× Profit margin 3%
EBITDA coverage 9× Return on total assets 9%
Inventory turnover 10× Return on common equity 12.86%
Days sales outstandinga 24 days
Calculation is based on a 365-day year.
Balance Sheet as of December 31, 2008 (Millions of Dollars)
Cash and equivalents $ 78 Accounts payable $ 45
Net receivables 66 Notes payable 45
Inventories 159 Other current liabilities 21
Total current assets $303 Total current liabilities $111
Long-term debt 24
Total liabilities $135
Gross fixed assets 225
Less depreciation 78 Common stock 114
Net fixed assets $147 Retained earnings 201
Total stockholders' equity $315
Total assets $450 Total liabilities and equity $450
Income Statement for Year Ended December 31, 2008 (Millions of Dollars)
Net sales $795.0
Cost of goods sold 660.0
Gross profit $135.0
Selling expenses 73.5
EBITDA $ 61.5
Depreciation expense 12.0
Earnings before interest and taxes (EBIT) $ 49.5
Interest expense 4.5
Earnings before taxes (EBT) $ 45.0
Taxes (40%) 18.0
Net income $ 27.0
a. Calculate those ratios that you think would be useful in this analysis.
b. Construct a DuPont equation and compare the company's ratios to the industry average ratios.
c. Do the balance sheet accounts or the income statement figures seem to be primarily responsible for the low profits?
d. Which specific accounts seem to be most out of line relative to other firms in the industry?
e. If the firm had a pronounced seasonal sales pattern or if it grew rapidly during the year, how might that affect the validity of your ratio analysis? How might you correct for such potential problems?